DIYARBAKIR, Turkey, March 14 (Reuters) - Kurdish politician Abdullah Demirbas is haunted by the nightmare vision of his two sons meeting in the hills of southeastern Turkey.

The first left home at 16 to join Kurdish rebels fighting the Turkish army, and now his older brother is signing up on the government side. Like many Kurds weary of a war that has killed 40,000, he prays talks between fighters and government will bring the swift, lasting peace that has eluded generations.

The Kurdistan Workers Party (PKK), whose leader Abdullah Ocalan is conducting talks from his prison cell on an island near Istanbul, is expected to declare a ceasefire next week. On Wednesday, the PKK freed a group of Turkish soldiers held prisoner in their mountain retreat in northern Iraq.

Previous contact with the man once dubbed "baby killer" by Turkish media was a closely-guarded secret, but the latest talks have been openly acknowledged by Ankara, risking the wrath of a conservative establishment.

There are perils for all and forces on both sides that stand opposed to talks. In the regional centre Diyarbakir, a city of anonymous apartment blocks ringed by centuries-old ramparts, the conflict eats into the heart of families and friendships.

"The worst thing that could happen in my life is for both of my children to come together fighting in one place," said Demirbas, a member of the pro-Kurdish BDP opposition party. His wife, he said, would stay up all night to pray when she heard fighter jets leave on sorties to bomb rebel hideouts.

"Maybe my child is going to die tonight," he recounted her saying of the younger brother, who left home four years ago to join the rebels in the highlands around the city perched on a bend in the Tigris River.

The three-decade Kurdish conflict has opened Turkey to accusations of human rights abuses and consigned the south-east to poverty. It has lso forced a nation eager for a greater role on the world stage to face up to its own ethnic diversity.

Progress in solving it has been painfully slow.

In this city of 1.5 million people, where boys selling tea and turnip juice dart among old men in traditional Kurdish baggy trousers, there is widespread resentment of a state which for decades denied Kurdish ethnic identity.

But whether driven by his presidential ambition ahead of elections next year, a path which would be smoothed by Kurdish support, or by fear of Kurdish assertiveness in neighbouring northern Iraq and war-torn Syria, Prime Minister Erdogan has a new sense of urgency.

Since October, intelligence officers and Kurdish politicians have been speaking to PKK leader Ocalan in the island prison where he was dispatched in 1999 after capture by Turkish special forces in Kenya.

What has emerged appears the most comprehensive effort yet to end the conflict with the PKK, considered a terrorist group by Washington and the European Union as well as Ankara.

"There have been many attempts at peace, but this one is the most serious," said Imam Tascier, head of the Revolutionary Democratic Cultural Associations (DDKD), one of several Kurdish leftist groups formed in the 1970s and a precursor to the PKK.

"Why? Because it is being carried out in the open. Previous efforts have disappeared without trace," he said. "But a ceasefire alone will not solve the problem, this is only the beginning."

The PKK originally demanded creation of an independent Kurdish state in the southeast but has now moderated its declared goal to autonomy within Turkey.

CAUTIOUS OPTIMISM

Erdogan has taken steps his predecessors would never have dared, including allowing Kurdish television broadcasts and elective Kurdish language courses at state schools.

But his administration has also overseen the detention of thousands of Kurdish politicians and activists in recent years, Demirbas among them, while last summer saw the heaviest fighting in more than a decade with PKK militants.

Leaks from the talks with Ocalan reveal a roadmap envisaging a PKK ceasefire from March 21, the Kurdish New Year, the withdrawal of fighters to northern Iraq and eventual disarmament in return for greater rights for Kurds.

"We are hopeful, with some reservations," said Demirbas, breaking off to be briefed on a convoy heading to northern Iraq to collect the Turkish soldiers being released from PKK captivity as a confidence-building measure.

"Concrete steps need to taken with urgency. We have no time to lose. If this is not solved now with all the popular support for peace, things will only get worse."

He reeled off a list of demands for the country's 15 million Kurds, who make up roughly a fifth of the population: changes to the constitutional definition of citizenship, mother-tongue education from primary school age, the strengthening of local government and a lower threshold for political parties to be represented in parliament.

On the street there are small signs of progress.

Defendants are using Kurdish in court thanks to a recent change in the law and some police officers are taking lessons to improve their Kurdish, a language outlawed until 1991.

"It is a process," said Aydin Altac, local head of Erdogan's AK Party. "When you look back to before 2002, you could not even say you were Kurdish, you could face prison. We are now talking about autonomy. Can you imagine the distance we have come?"

ECONOMIC DIVIDEND

Diyarbakir's economic fortunes have dwindled as the rest of Turkey prospered, the violence and stigma deterring investors.

"We try to explain to entrepreneurs who come here that this is not a violent place," said factory owner Aziz Sagir, sharing a plate of sweet semolina with colleagues in a central caf?.

"But we suffer from prejudice  Unfortunately we are seen as potential terrorists."

Diyarbakir fell from third place on the country's socio-economic index in 1927 to 63rd out of 81 provinces by 2003, according to the International Crisis Group. Per capita income, estimated at around ${esc.dollar}1,500 in 2009, was less than a fifth of the national figure, while unemployment is as high as 20 percent.

Its potential to catch up could be huge.

Turkey is hoping to find shale gas reserves big enough to help reduce its dependence on energy imports, with a basin around Diyarbakir seen as one of the hottest prospects. Shell is already drilling in the region.

Turkey is also a major trading partner for northern Iraq's autonomous Kurdistan region, importing crude oil in exchange for diesel and exporting grains and construction materials like sandstone and marble, trade which could flourish.

"Imagine a world where Turkey's southeast is at peace, where energy earnings from northern Kurdish Iraq fuel investment in the region and foster open trade," said Christian Keller, a former IMF representative in Turkey and now a senior economist at Barclays Capital in London.

Some Turks fear the emergence of a strong autonomous Kurdish region in northern Iraq and the civil war in Syria, where Kurds have asserted control in parts of the northeast, could embolden Kurds within Turkey and threaten its unity.

But in Diyarbakir there have been fewer funerals in recent months and the overwhelming sentiment appears to be that everyone is tired of the fighting. For now, they are ready to give Erdogan the benefit of the doubt.

"Forty thousand people lost their lives and nobody won," said Demirbas. "It is time for peace."

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